The Death of Drive

Anyone looking for some interesting reading may want to look for a copy of T.J. Stiles’ fantastic biography of Cornelius Vanderbilt, The First Tycoon. Having just finished it’s difficult to deny the degree of insight revealed – not just about the subject, but, as significantly, about changing market trends within the United States over the past two centuries.

Consider, for instance, that at the start of Vanderbilt’s life and working career (1790s and early 1800s), the US economy was still almost entirely agrarian and artisan in nature. The vast majority of people were basically self-employed; whether farming or blacksmithing, most people had “hung out their own shingle” to borrow the popular phrase.

The duration of Vanderbilt’s life coincided with (or possibly catalyzed, depending on your point of view) a very interesting trend away from the old economy and to a new industrial economy. This shift marked not just the growth, but essentially the birth of the wage worker and the middle manager. People suddenly started, on a mass scale, to labor for others or manage companies that were owned not by them, but by shareholders.

Obviously since the time of Vanderbilt this trend has continued to grow. The US and global economies have mostly consolidated among a handful of humongous conglomerates whose workers and managers own only marginal proportions of their respective companies. Without a doubt, at some point this shift will end and begin to change directions – as all trends do.

In a similar vein, there are several interesting aspects today in the world of venture capital that are worth discussion and consideration. For example, commonly accepted knowledge in the venture funding world claims that 65+ percent of all start-ups will fail. Maybe 30% will become self-sustaining and eventually pay their investors some decent rate of return. Hopefully 5% are homeruns, the profits from which will not only make up for the total loss in 65%, but also boost returns to beat market averages.

This thinking – and the way start-up founders, managers, and investors have reacted to it – is interesting to note. The process that’s evolved has shown the popular delusion of modern portfolio theory taking root, with VC firms now making a large (and growing) number of smaller investments in a broad array of start-ups. Based on the claim that there’s no way to guess which start-ups will flourish, investors simply try to play the numbers game, a major divergence from the old ways.

In the old days – in venture capital and other arenas – people focused their investments. In the early 1800s people had their entire livelihood and net worth wrapped up in their own business, whether a farm or a steamboat ferry. By the mid-1800s and mostly through the end of the century (i.e.: even after the growth of corporations), investors still focused capital in a small number of companies that they knew or to which they had some close affiliation.

At that time, many if not most ideas for new businesses went totally without funding and simply fell by the wayside, while today almost every new idea can get funding. The difference lies in the results: when people invested in new companies two hundred years ago, those companies were expected to succeed. The founders of those that didn’t were at the end of their careers in the start-up world; failure followed them. Nowadays failure is the norm. Start-up founders who seek funding are less likely to find willing investors unless they have couple failures under their belts.

It’s interesting to note that when modern portfolio theory was first introduced, it was meant to encourage diversification by investors among companies in different industries and geographic areas, but also to encourage diversification among various asset classes, exposing investors to different levels of risk. Now we see its precepts acting within individual asset classes like venture capital. The process can be nearly equated to the theory that, if subprime mortgage-backed bonds are divided into tranches, higher tranches are somehow less risky.

Also interesting is how so many people can misunderstand the nature of the numbers game they’re trying to play. Think of flipping a coin: on any given flip the heads/tails odds are 50-50; and yet so many people think that if a flipped coin shows heads ten times in a row, the chances of coming up tails somehow rise – as if it’s “due” to happen.

Things are the same way in the investment world. Using our venture capital example, in order for the 65-30-5 rule to apply investors would need to make equal investments in every single start-up company in a given year. If they just go out and pick a few, on any individual selection there is a 65% chance that they will lose their entire investment.

The last, and perhaps most, interesting thing to note given these long-term trends has been the American settlement for mediocrity. Risk aversion in this country is running rampant, as detailed in a recent Wall Street Journal article by Ben Casselman. Start-ups are among the very riskiest of investments, but people have scaled down the size of their investments (read: risk exposure) to each individual start-up. In exchange for spreading their eggs among more and more baskets, investors now hope to achieve, over a longer period of investment and in a much larger number of companies, a barely-better-than-average rate of return.

In other words, Americans have settled for comfort and shunned risk. In their livings they have stopped hanging out their own shingle and flocked to large conglomerates with cushy salaries and health insurance, while someone else (the passive shareholder) benefits from the products of their labor. In their portfolios, they have stopped taking direct interest in the companies where they allocate (not concentrate) capital. Instead, they’ve taken a more passive role, deferring to those who manage their large and growing number of marginal interests.